The second major issue addressed by the FDIC options paper on deposit insurance is how to fund insurance losses or, stated another way, how to maintain the funds over time. Because of current statutory restraints on assessing deposit insurance premiums when the fund balances in the BIF and SAIF exceed the “designated reserve ratio” (currently 1.25 percent of insured deposits), the FDIC does not collect premiums from most institutions when times are good. In contrast, when the reserve ratios fall below 1.25 percent, the FDIC is required by statute to charge high premiums (23 basis points). Thus, during adverse times when banks can least afford it premiums are highest, and the surviving banks pay the costs of the failures. The result, according to the options paper, is that “we have clearly departed from any concept of spreading insurance losses over time.”

From 1934 to 1950, banks were assessed a steady fixed premium of 8 1/3 basis points. From 1950 to 1989, due to concerns that the fund had grown too large, the FDIC was required to return a portion of excess premium revenue to banks each year, depending on the FDIC’s expenses. As a result of the refund system, premiums ranged from approximately three basis points to 8.33 basis points. After 1989, Congress set the designated reserve ratio for the funds, and premiums depended on whether the reserve ratio was above or below the target. As a result of these changes, the original system with a focus on a steady, long-term premium rate has been replaced by a system that focuses on a hard target reserve ratio and leads to volatile premium rates.

The options discussed by the FDIC for remedying this perceived flaw in the system fall into two categories: the user fee model and the mutual model.

User Fee Model

The user fee approach views the government (not the banking industry) as the provider of deposit insurance and the party responsible for bearing the risk of guaranteeing deposits. The industry would pay on a regular basis for access to the system. Premiums would be viewed as paid in exchange for value; the industry would have no claim on previous payments (just like private insurance where the driver of a car who does not have an accident does not get his money back).

The options paper outlines two general approaches to the user fee model. The first relies on steady average premium rates designed to match premium revenue to insurance losses over the long term. The second alternative allows for more variation in the average premium rate depending on the level of current insurance losses or the reserve ratio of the deposit insurance funds.

Under the simplest user fee model, banks would pay a stable average premium rate based on historical experience, either set in statute or subject to infrequent change by the FDIC. The key issue in this approach is setting the right premium rate. What historical period is most relevant? An inflexible rate will not account for changes in industry structure, regulation and the competitive environment. To match premium revenue with fund expenses and bank failure losses based on the 1980 to 1999 time period, the premium rate would be 11.2 basis points. Using 1934 to 1979, the premium rate would be 1.0 basis point; using 1934 to 1999, the rate would be 8.5 basis points. Using a “moving average” is also a possibility. For example, using 10-year, 15-year and 20-year moving averages during the 1934 to 1999 period yields an annual average premium of about 4 basis points (3.6 to 4.4 bp).

To avoid significant buildups of the insurance funds or prolonged periods of losses to the funds resulting from a fixed premium rate, the FDIC could also tie pricing more closely to current performance. It could make up or down adjustments in the long-term premium rates within a defined range (say, 5 basis points in either direction) to account for excess revenues or a revenue shortfall. Or it could tie adjustments in the long-term rate to the funds’ reserve ratio using a “soft target.” Under this approach, premiums could vary up or down within a defined range, but no adjustment would be made unless the reserve ratio moved above or below a certain range.

The FDIC’s analysis of different premium scenarios suggests that a system can be established with a finite premium range, no negative or zero fund balance over time, and no frequent or large premium changes.

Mutual Model

The options described under the mutual model include rebates tied to a reserve ratio or a system where banks hold claims on the insurance fund. The basic notion is that banks are treated more like owners of the funds—sharing the excess buildup through rebates, but subject to a capital “call” to make up shortfalls.

The reserve targeting approach to rebates would put a cap on the insurance fund and rebate funds above that amount. Rebates raise the issue of how best to allocate them, the FDIC notes. To be fair, rebates would have to be based on past payments into the fund, not on deposits or some other assessment base.

The credit union insurance system is another example of a mutual model where institutions have a claim on the fund. Credit unions are required to maintain an amount equal to one percent of their deposits in the insurance fund. When the fund exceeds a certain range, rebates are provided. Under this model, when an institution’s deposits grow, it must make a proportional contribution to the insurance fund to account for the growth. When deposits shrink, the institution gets a rebate or credit.

Such a system would address the problem of new deposits coming into the system without any premium payment at new or fast growing banks. But it would also represent a significant increase in the costs of chartering a bank or gathering new deposits. These concerns could be mitigated somewhat if the payment could be made over time. Another challenge is how to transition to this system from the current one and allocate the amounts currently in the BIF and SAIF to individual institutions.

Funding Systemic Risk (Too Big to Fail)

The FDIC also raises the issue of how to recoup the costs of assisting or resolving very large banks that pose systemic risk to the financial system. Currently, the FDIC may not pay uninsured depositors or creditors unless the Secretary of the Treasury, upon the recommendation of the FDIC and the Federal Reserve, determines that the bank’s failure poses a systemic risk. Once systemic risk is invoked, the FDIC’s costs are recovered through a special assessment levied on all institutions based on assets.

The options paper notes that this arrangement contributes to premium volatility and imposes costs on smaller banks that would never enjoy systemic risk protection. Also, some large complex financial institutions also pose systemic risk but may not be part—or not wholly part—of the deposit insurance system.

The FDIC asks whether systemic risk funding for banks should be removed from the deposit insurance system and funded as it is for other financial firms or for commercial companies. It also asks how the costs of systemic risk should be distributed. While more of the cost of systemic risk relative to regular assessments is borne by large banks because assets are assessed instead of deposits, small banks still pay. Does a small bank benefit more from the special treatment of large banks than do other small businesses or other large nonbank financial companies? the paper asks.

The options paper is posted on the FDIC Web site (www.fdic.gov), along with a series of questions designed to elicit public comment. Viewers can respond to the questions directly on line. Among the questions posed on funding losses are: whether the user fee notion or the mutual model notion is preferable; how to strike the balance between maintaining stable premiums versus maintaining a stable fund; how to set the average premium rate under the user fee model; whether premium rates under a user fee model should be adjusted for current insurance expenses, linked to the insurance fund, or tied to a hard or soft target; how rebates should be determined and allocated under a mutual system; and whether the current mechanism for funding systemic risk exceptions is appropriate.